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CLS: Federal Reserve, Interest Rate Increase, French Elections

12/16/2015

Week in Review
Markets got hit with a cold spell last week. The S&P fell 3.7% and small-cap stocks sank 5.0%. International markets outperformed domestic stocks, falling 3.1%. Bonds rose 0.5% and commodities dropped 4.0%. Oil prices sank 10.9% to $35.62 per barrel. High-yield bonds also sank. Two ETFs tracking the market fell around 2%.

Market participants reacted to the specter of a Federal Reserve (Fed) interest rate hike, volatility in the high-yield bond market, and further declines in oil prices. The downturn, while relatively small, pushed domestic stocks into negative territory for the year.

Federal Reserve is About to Make History
“What were you doing the afternoon of December 16, 2015?”

That question is overdoing it. The Fed meeting and announcement this week won’t rate as highly as some of the defining moments in American history. Yet, the Fed’s likely announcement of a 0.25% increase in rates is important for the markets and economic history.

Increasing rates would be the most important step toward financial normalization taken in the aftermath of the global financial crisis that has dominated U.S. monetary policy since 2008. Interest rates have been close to 0% for over six years. Low rates have lowered the incentive to save and benefited borrowers. While 0.25% isn’t much of a return, increasing rates signals that the Fed believes the crisis is being overcome.

The small increase also serves the purpose of defending the financial system against bubbles. Extremely low rates create investment models that are heavily reliant on leverage. When systematically important financial  firms take on excess leverage, it makes the system more risky. Firms use leverage to invest more money, causing their preferred investments to rise in price. Other investors pile in and a bubble can ensue. A hike would serve as a shot across the bow that low-cost leverage may not be around forever.

Bond investors will no longer have the steady benefit of declining rates to support prices. If the Fed comes through, the downward trend in interest rates will change for the first time since June 2006. Treasury bond investors, in particular, have benefited from low rates and the Fed buying up bonds to spur the economy forward.

Other asset classes have benefited from income investors seeking to maintain investment income in the face of low and falling rates. Dividend-paying stocks, preferred stocks, investment- grade corporate bonds, and high- yield bonds have all benefited from investors chasing yield. Now, investors will potentially be able to maintain yield while moving out of these riskier market segments. The reduced demand for the high- yielding segments of the market could increase volatility across formerly tame sectors.

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